Gray Report Notes: July 9, 2022

Every week, The Gray Report publishes a video and podcast that covers the latest news, research, and reports from the multifamily industry, commercial real estate markets, and the economy. Below are some of the notes associated with our weekly video, podcast, and newsletter as well as the links to the sources that we discuss. These notes may be rougher and more conversational compared to other blog posts and publications from Gray Capital, but they provide additional insight into our ongoing discussion of the most important news and research for apartment investors.

INFLATION

Bloomberg: “Inflation Is Here to Stay and That Makes a Recession Inevitable” – https://www.bloomberg.com/news/newsletters/2022-07-05/inflation-is-here-to-stay-and-that-makes-a-recession-inevitable

• An alternate title to this article could be “Rising Rents for Housing Will Cause the Next Recession.” The finger has been pointed in this article, AND THE FINGER POINTS TO THEE.
• I love articles like this that just straight-up tell me what is going to happen. Not what’s expected or projected but what’s inevitable. Given this article’s certainty of doom, anything good that happens in the next year is like an unexpected bonus!
• CPI Numbers for the month of June are due in about a week, but I don’t think that people are holding off on their discussions because they’re scared of getting their inflation predictions wrong.
• Most of these are predictions of more inflation.
  • Many of these, I suspect, are simply the same article written over and over with the names and dates changed! For those economic reporters who aren’t writing the same article, I’ve got a neat formula that is going to make your job a LOT easier:
    • Start off with the latest CPI numbers (it doesn’t matter if they are a little stale, just use what you have).
    • Then you’ve got a paragraph on the Federal Reserve, maybe throw in a quote from Jerome Powell.
    • Then, and this one is crucial, you’ve got to talk about gas prices. Preferably, you’ll have a picture taken of a beleaguered motorist pumping gas with the prices prominently displayed in the background.
    • Add a couple more price hikes on food and cars, get a quote from the average citizen, close it out with recession fears, and you’ve got yourself an article.
  • This Bloomberg article is far better than the formulaic inflation articles I’ve been reading for the past 2 years, but it does include a component that I am seeing much more in recent coverage and commentary on inflation: Housing.
    • We have been following housing prices and inflation very closely, especially rental housing, and for as much as housing prices have risen in these past two years, the categories of housing rents and owners equivalent of housing rents have not exceeded the CPI or Core CPI inflation rate. The latest CPI numbers are for May, and they have rents up by 5.2%, Core CPI at 6%. Owners’ equivalent of rents is up by 5.1%.
    • A 5.2% increase in rents is higher than the 6% Core CPI number. Now, Core CPI excludes food and energy prices, so, if you put those back into the mix, inflation is at 8.6%.
    • Admittedly, I am a little bit surprised that the rent growth measured by the census is as low as it is, but this is likely due to measuring in-place rents rather than market rents. Most of the multifamily reports that we cover have year-over-year rent growth at twice the rate recorded in the CPI, but that doesn’t mean that the CPI’s numbers are wrong. 
      • Another suggestion for reporters writing about inflation and housing: If you really want to get people talking about the housing affordability crisis, compare the Apartment List rent growth number (14.1%) with the Core CPI number (6%).
  • To return to the Bloomberg article, the author, Edward Harrison, is strikingly confident about how things are going to play out: “Increasingly, first time homebuyers are getting priced out of the market. And that will put upward pressure on rents. With recent consumer spending data already weak, the prospect of further tightening will be too much to bear for the US economy.”
    • It sure seems like Edward Harrison is saying that increases in housing costs, specifically rental housing, is going to be the straw that breaks the camel’s back. We’ll discuss a RealPage article that may run counter to those assumptions.
    • I touched on the tight vacancy and (slightly) lower rent growth for renters-by-necessity, and a CBRE report that we’ll discuss shortly also finds the same tight vacancy and lower rent growth in the single family rental space.
    • Why am I mentioning this? Because it is not the case where rents are this mindless, insensate force of increase and burden upon a struggling population. Landlords and property managers are getting signals, often from sophisticated rent management software, that are finely tuned to renters’ ability to pay, and they are adjusting their rents accordingly.
    • Yes, housing prices (including rent!) are a significant and influential factor in household budgets and inflation more generally, but as much as these prices move the economy, they are also moved by the economy. Home prices have cooled off because people aren’t buying homes as much.
    • Rents may not be cooling off the same way as the price of a house, but they certainly are not rising the same way for every single market in America.
      • Take Phoenix, for example. Incredible rent growth for the past two years and easily one of the top markets in the country in that time.
      • According to the Apartment List report we covered last week, for the past six months, Phoenix had the LOWEST rent growth in the United States, only growing by 1% compared to the 5.4% national average.
      • I can’t—wait—could this be an example of landlords and property managers responding to a population of renters that are increasingly unable to pay and therefore adjusting rents accordingly? I would say yes, that’s kindof my take on it.
      • If you want to conjure up an image of a rent growth boat approaching an iceberg unable to stop itself, feel free, but even though housing is a necessity with a certain amount of inelastic demand, the housing market does respond to market signals.
  • According to a Bloomberg model from April of this year, housing rents are projected to increase to 7.2% by the end of the year, and they are at 5.1% right now.
• Ultimately, the big risk that Edward Harrison highlights here is that the Fed could raise rates to curb inflation, trigger a recession, try to lower rates to counteract that recession, cause more inflation that follows those lower rates, then trigger another recession.
• One silver lining in his closing comments: “I do think that there is fundamentally less room for companies to cut physical capital and human capital investment than in any business cycle I have personally witnessed.”

RealPage: “How Do Rents Move in a High-Inflation Environment? Look to the 1970s.” – https://www.realpage.com/analytics/rents-move-high-inflation-market-look-1970s/

• Rents move up. That’s what they do.
• The author, Jay Parsons, puts it a little more artfully than I: 
  • “From 1974 to 1985, a stretch that included three separate economic contractions, rents increased 7% to 12% each year. That’s pretty close to where we are today, and perhaps a sign of what’s to come with rents if inflation persists. And it’s a reason we’re skeptical of reversion-to-mean rent forecasts, even if the economy continues to soften.”
• I have been talking a lot about what might happen if they have been moving up and how the renter population has responded to increased housing costs, and last week we discussed how lower-income renters may be feeling the impact of these rising costs more acutely than higher-income renters.
  • Rent growth in Class C properties has been lower than the growth in Class A or B.
  • But rents are still growing. Even just taking Class C properties isolated from the multifamily market as a whole, these properties are still seeing substantial growth (Yardi Matrix has Renters-by-Necessity paying 13% more year-over-year compared to 14.9% for Lifestyle renters), but the comparative sluggishness of Class C rent growth, combined with the comparative tightness of the Class C apartment market, is worth watching.
  • According to the Atlanta Fed Wage Growth Tracker, yearly wage growth for the third and fourth quartiles is 4.3% and 3.6%, respectively. The first and second quartile wages grew 6.7% and 5.7%, so there’s a clear divergence in wage growth depending on income level.
• Comparing the rent growth graph in this article with the CPI numbers for the same period shows that rents held strong throughout multiple inflationary periods. Link to FRED graph of CPI for 1974-Now
• There are challenges: “Of course, it doesn’t solve for the rising cost of capital in getting new deals done. But it positions current owners well through an inflationary period. (In fairness, profit margins are likely to thin due to expense pressures, but the ability to at least keep pace with inflation is a “win” in this environment.)”
• Ultimately, for this article, it could be reduced household formation that will happen in a stagflation environment, such that “we’ll likely see more renters doubling up with roommates.”
  • There are some large-scale demographic developments associated with household formation, like, what are the millennials or baby boomers or zoomers doing for housing right now? What are the Gen X-ers doing? 
  • I’ve seen estimates of the specific generations like that, but in reality, household formation is pretty volatile. (Link to graph of household formation).

RENTAL PAYMENTS

Multifamily Dive: “15% of U.S. Renters Are Behind on Their Rental Payments” – https://www.multifamilydive.com/news/15-of-americans-behind-on-rent-payments/626467/

• 15% of renters are behind on their payments, according to the household pulse survey from the census bureau.
  • Now, to provide a little bit of context, the rent payment rate has been around this same level for months. It was 84% in the previous household pulse report, and it was around 84% this past December.
• This article really is a collection of sources that highlight the increased challenges of the affordability crisis for lower income renters. Lower income renters, instead of 15% being behind on their payments, 20% are behind on their payments.
• For renters making $100-150k, only 3.5% are behind on their payments.
• Ultimately, increases (or decreases) in wages could be the determining factor here. This article does rightly highlight the increased struggles of lower-income renters, especially as inflation eats away at a greater portion of their spending power.
• Could we be facing a situation where increases in other areas like gas and food put downward pressure on rent growth? 
  • I think this might be true to an extent, and it could be playing a role in the reduced rent growth and higher delinquency rates for lower-income renters, but I don’t think that this article is making that point.
  • The article points to wages as the key factor, I would argue, because even though a dollar does not go as far as it used to, finding the right housing ranks at or near the top of the list of priorities for most people. I could be way off here, but I think that people would much rather compromise with cheaper, less desirable groceries than they would compromise with cheaper, less desirable housing.

ARE PRICES GOING DOWN?

GlobeSt: “Cap Rates Might Finally Start to Rise Again” – globest.com/2022/07/01/cap-rates-might-finally-start-to-rise-again/

• “Since capitalization (cap) rates are a measure of return on an asset, higher ‘risk-free’ rates mean sellers will need to reduce their price expectations or increase cash flow, if that’s an option, to entice buyers seeking competitive yields, which should also push cap rates up,” First American senior commercial real estate economist Xander Snyder said in prepared remarks.
• Currently, cap rates are still at near-record lows, but the PCR model suggests that slower price growth is likely to push cap rates up. But not all CRE property types are in the same position. “Multifamily and industrial assets set first-quarter price growth records, increasing at a faster rate than any other first quarter in the past 20 years, while office and retail assets were a drag on overall CRE price growth in the first quarter,” Snyder said. “However, a record amount of industrial square footage is currently under construction and expected to come to market later this year, which may slow price growth for industrial assets and put further upward pressure on the potential cap rate as the year progresses.”
• So, reading between the lines here, they say that office and retail were a drag on price growth, and they say that industrial asset prices might go down because of the record amount of square footage coming on to the market.
• So, office, retail, and industrial have other factors beside the increase in interest rates that could lead to cap rate expansion, but not so for multifamily. That being said, the increase in interest rates is a market-shaping force. 

National Association of Home Builders: “Have Building Material Prices Peaked?” – https://www.nahb.org/blog/2022/06/have-building-material-prices-peaked

• Lumber prices are down, which is great for multifamily developers bringing new apartment supply into the market, but not all of the construction materials needed are as easy to buy. This report suggests that we could see a lot of these materials prices to go down.
• Steel went up a lot last year, but at least, I guess, it’s nice that it hasn’t really increased its price too much in 2022. Six months with like, a 3% price increase is pretty great considering the increases we saw in 2021.
• It’s reduced demand that is driving this reduction in materials costs, particularly the reduced demand that has followed the increase in mortgage rates for homebuyers. 
• At the same time, for individuals, or more relevantly investors, who can create a plan to mitigate the difficulties associated with interest rate increases, could there be an opportunity in this changing environment?